Real Regulators Aren't Magicians, And They Usually Screw Up

from the why-regulations-tend-not-to-work dept

Last week we noted that Larry Lessig wanted to get rid of the FCC, and replace it with an agency that was designed to get rid of regulations, rather than add them. As we noted, no matter what the good intentions of regulators who are tasked with deregulating, it's unlikely it would turn out that way. It wouldn't be long before lobbyists and corporate interests were able to turn the "deregulators" into regulators in their favor. Related to this, Tim Lee points us to a good old fashioned barn burning rant from Jim Harper that should be a must read for anyone who thinks that today's financial crisis shows why we need more regulation. Harper is responding to a conversation on a recent episode of Meet the Press where some commentators were discussing the Bernie Madoff fraud, and noting that it shows the need for "real regulators." Harper then points out that we have real regulators and those regulators fail, regularly. And that's the problem.

People who support increased regulations do so under the mistaken impression that such regulators do the right thing most of the time and are able to spot fraud and stop fraud. That's quite rare. What happens instead is that such regulators are very fallible, and often co-opted by the very industries they're supposed to be regulating. Real regulators don't work nearly as well as the imaginary perfect regulators we'd all like to see -- and they often give us a false sense of security. It's what makes people think that a scam like Madoff's couldn't happen. The "real regulators" were alerted to Madoff's questionable activity time and time again. The real regulators also stood by and didn't realize the extent of the problem in the mortgage market. It wasn't a lack of regulations that was the problem that resulted in the financial crisis -- it was the fact that people actually thought the regulators who were in place were protecting us from such a mess. Real regulators are a problem. Imaginary, platonic ideal regulators would be great, but they don't exist.

When regulators fail to address a problem ahead of time, when they regulate inefficiently, when they hand their rulemaking organs to the industries they are supposed to oversee, those are all the actions of real regulators. That's what you get with real regulation.

What Burnett meant when she called for a "real" regulator, of course, was "the regulator I can imagine." The regulators people imagine are foresighted, interested only in the public good, they're resistant to lobbying, and they run efficient organizations. But these characteristics are simply imaginary.

Watching discussions like these, you come to realize how legislation and regulation thrive on self-deception and the appeal to ego.

Thousands of people come to Washington and stay because they believe that they can design the ideal regulatory system. They think they know how to write a law or a regulation that works for everyone, that protects consumers, that doesn't pick winners and losers in the marketplace, that doesn't make the glaring errors that we see month in and month out on Sunday morning political shows.

(If only voters didn't elect the wrong guy. If only lobbyists didn't 'corrupt' the system. If only, if only, if only . . . .)

Alas, we're stuck with real regulators. They fail, and when people rely on them, the failures of regulation are magnified.

Regulators and the market

If someone speeds and causes an accident, does that "prove" that traffic laws are ineffective?
The problem with regulation is TRANSPARENCY, not the system! If we have an opaque system of any sort, it will fall under the control of special interests. Bush-Cheney proved that. If we have a transparent system, it may fail, but it will also be fixable; since we can clearly see what went wrong.
On a larger note, there is a tendency to put someone in a position of power, and then "get out of the way". Short term, things get done more quickly and efficiently - long term, we have abuse and corruption (too much power).

gun control analogy

People have the same ideas when it comes to gun control: "lets make a magic law that fixes everything", while ignoring the fact that the laws are already in place. I saw story on our local news the other day - someone was hunting where they shouldn't have been and shot out the window of a daycare center. The hunter was arrested and in custody but the first bystander interview says "It's good they caught the guy and all but we need more laws against this kind of thing". Huh?

Re:

Who?

One of the 1st things I was taught as part of a critical thinking course was to ask the question: 'who is saying this?' In other words, what is the motivation behind the person writing the piece. It got me to thinking further - not just who, but what are they defending?

When you look at regulation - and the current reaction to mark-to-market is a great example - we find it is the Fed that's slinging its weight. And who is behind the Fed? Not the government as you might expect but private banking interests.

Take that thought and apply to the notion of regulation and you quickly conclude that regulation is a matter of what suits the interests of those who regulate at any point in time.

Now look at the Fed's balance sheet and you also see that it has become the biggest hedge fund of all time in the last year. No wonder they don't want mark to market. If they did then they'd be well and truly up shit's creek without a paddle.

Nuclear Power Tangent

On a tangent, this is basically the crux of the anti-nuclear power argument. Sure, nuclear power beats fossil fuel if handled properly, but that's a big "if". Safety adds to the operating cost of a nuclear plant and it is only natural that capitalistic, profit-driven owners would want to reduce costs in order to increase profits. So what keeps them from shorting safety? Regulators. But it has been seen time and again that regulators cannot be trusted. Therefore, nuclear power cannot be trusted.

Bye bye TechTrash

I used to see technical news here, sometimes even something that hadn't already been covered by a bazillion other tech sites first. Lately, though, all I seem to see are fallacy-laden laissez-faire rants from Masnick. This time it's argument by demanding impossible perfection, a cross between strawman and moving the goalposts. Because real regulators aren't perfect - a position nobody actually holds - he concludes that we'd be better off without. The question of whether regulatory failures and corruption are actually frequent and/or severe enough to make regulation worse than the failures that can occur in its absence never even gets asked. The medicine has side effects, so suffer the disease in silence. Such posts are uninformative, dishonest, and above all boring. Grow up, Mike.

Re: Bye bye TechTrash

Heh. Didn't you swear off the site a month ago too?

This time it's argument by demanding impossible perfection, a cross between strawman and moving the goalposts.

I'm not demanding impossible perfection. I'm pointing out that those who support increased regulation often ignore the fact that regulation rarely works as predicted, and the unintended consequences of bad regulation is often much worse than no regulation at all.

Because real regulators aren't perfect - a position nobody actually holds - he concludes that we'd be better off without.

No, that's not what I said either. I am pointing out the failings of thinking that regulation solves everything -- with evidence that it does not.

The question of whether regulatory failures and corruption are actually frequent and/or severe enough to make regulation worse than the failures that can occur in its absence never even gets asked.

Actually, it does. We discuss it quite often. I thought you said you read the site?

Such posts are uninformative, dishonest, and above all boring.

That's quite a trio of accusations. I guess you're gone, but if you're going to accuse us of all three things, while also complaining that we don't actually expand on our positions, it's rather... weak, to then make such claims without explaining any of them.

If it's so "uninformative" then why do so few people understand this (yourself included, apparently). If it's dishonest, what's dishonest about it?

If it's boring... well... why bother commenting at all? Why not move on to another post?

Grow up, Mike.

And, conclude on a childish taunt. Lovely. Very convincing. Thanks to this post, I'll ignore all of economic history and change my mind about everything I say.

Re: Re:

Yeah, I guess I don't agree that this is such an impossibility. It requires radical reform, though, and some fundamental changes to the way we think.

It seems the crux of this Tim Lee/Mike argument is that because so many existing regulators suck so badly (agree), it's impossible to have good regulators ever, anywhere (disagree).

I don't think we've even tried. All we've done is stock lobbyists in regulatory positions. Now we're complaining that because these lobbyists are doing such a horrible job, that the idea of effective and competent regulation is a myth?

Re: Re: Bye bye TechTrash

"I'm pointing out that those who support increased regulation often ignore the fact that regulation rarely works as predicted, and the unintended consequences of bad regulation is often much worse than no regulation at all."

I understand that direct proof would be impossible to gather here, but can you offer any evidence in favor of this statement?

If the SEC had held the top 5 investment banks to a 12:1 leverage ratio, instead of relaxing the rules to let them go up to 30:1, the impact of the current financial crisis would have been significantly eased.

There are also reems of regulations devoted to preventing business from giving a false picture of their financial health. Do you think that transparency would increase if these were removed, or that this form of transparency is somehow not needed?

Would removing the laws (just another form of regulation) against Ponzi schemes would somehow prevent frauds like Madoff's?

I agree that constructing perfect regulations is an impossible task, but just throwing up your hands in the face of that doesn't point towards a solution. Sure, in a perfectly efficient market inherent forces would drive business towards policies such as transparency and appropriate leverage ratios simply because they're more effective long-term, but this assumes that business leaders can be as perfect as the idealistic regulators (foresighted, interested in the public good, efficient, etc.).

The physicist Neils Bohr said that the defining difference between a great truth and a minor truth is that the opposite of a great truth is also a great truth. I'll concede that "Regulation creates problems" is a great truth, but so is "Lack of regulation creates problems". It seems to me that the interesting work here isn't in deciding whether or not regulation is good in the abstract, but in trying to determine how to construct a practical regulatory framework that is spare enough to allow innovation through but tight enough to catch fraud. It's certainly a very tricky problem, but I'd need a lot more evidence to be convinced that it's harder than figuring out how to live without regulation at all.

Re: Re: Re:

Yeah, I guess I don't agree that this is such an impossibility. It requires radical reform, though, and some fundamental changes to the way we think.

I'd love to see a plan that actually worked, but they always get co-opted and corrupted. Even if you could maybe get it to work for a brief period of time, the influence of those being regulated is way too strong and the unintended consequences are way too painful.

It seems the crux of this Tim Lee/Mike argument is that because so many existing regulators suck so badly (agree), it's impossible to have good regulators ever, anywhere (disagree).

I should be clear: I don't think it's *impossible* to have good regulators ever. I think it's very possible. I just think it's rare, and in that rarity is the problem. Most regulators will end up sucking. You may get a good one every once in a while, but the damage done by all the bad ones in the meantime is a serious problem.

No regulation

Periphera covered most of my thoughts above, but it's also worth noting that the worse financial messes occured in the almost TOTALLY unregulated derivitives markets, just like the stratospheric rise in gas prices last summer came from rampant speculation and trading in gas and oil markets. ANOTHER unregulated and largely unmonitored marketplace.

Having efficient regulatory systems may be a problem, but I also think having no regulation whatsoever simply gives the greedy and the corrupt an even bigger incentive to manipulate the system to their own ends.

Mortgages

"The real regulators also stood by and didn't realize the extent of the problem in the mortgage market."

It doesn't help when the word comes down from on high to back off either. A "home in every pot" was a prize cornerstone of the Bush administration's economic policy, and anyone who stood in the way or made waves was about as welcome as a union rep at a WalMart manager's meeting.

Re: Re: Re: Re:

"I'd love to see a plan that actually worked, but they always get co-opted and corrupted."

In most cases they're coming directly from positions as lobbyists for the companies they then proceed to regulate. That strikes me as the problem. Not that regulators are just consistently utterly incompetent. They're utterly incompetent (usually) by design.

I agree with the idea that enforcing existing ideas effectively makes more sense than ladling on cumbersome new rules.

But I'm not sure I'm grokking Harper/Lee's larger argument that regulation in and of itself is inherently dysfunctional. Stocking positions with paid lobbyists tends to not work out very well. Does that mean regulation itself is the problem, or a bought and paid for government is the problem? They seem to shift the blame for the latter onto the former....

The Real Job of Regulators

The market is supposed to be full of “self-correcting” mechanisms: if someone tries to charge too high a price for something, customers will go elsewhere. And if they sell something for too little, they will go out of business.

But to someone with an engineering background, the market is a dynamical system. That means that the feedback mechanisms take time to react, and the delay between the stimulus and the response leads to instabilities and oscillations. Or what the economists know as boom-bust cycles.

Think of it as being like a car’s suspension system. The springs, left to themselves, will cushion the bumps, but they’ll cause the car to bounce around in a way that makes the passengers sick.

So the solution is to add shock absorbers. These actually slow down the suspension system’s response to the bumps. Or, in the economic marketplace, the equivalent of the shock absorbers is the regulators: their job is to make the market respond less efficiently to stimuli. By reducing the responsiveness of the market, they help to dissipate the potential for instabilities and oscillations.

Re: Nuclear Power Tangent

Losing a multi-billion dollar nuclear reactor would be enough of an incentive to keep it safe. Blowed up power plants are useless.

Would you remove the brakes on your car to save some money? No, that'd be stupid, as would side stepping safety in a nuclear plant.

You lose a couple plants to cost cutting, and good luck trying to get money to build another one. Who the hell would fund the venture, because it certainly isn't making money with no working power plants.

No to mention the lawsuits said blowed up power plants would create from families of dead victims, sick victims, and property damage.

What regulators?

This post is rather rich. For the last 8 years (at least) we've had a vastly under funded and under staffed financial regulation structure, headed and staffed by those who don't believe regulation is necessary. Underlying this insanity, we had the repeal of the very piece of regulation (Glass-Steagall), which prevented the exact disaster we're now experiencing, in a lame duck session on the eve of the 21st century.

Doesn't this Mean the Absence of Regulation!

First, I am not defending regulators who are not doing their job in one manner or another.

Second, we are incessantly scolded that we need less regulation to promote the free market. Well, if the regulators aren't doing their job isn't that free market nirvana!!

Instead of hearing the boastful gloating of the anti-regulatory crowd claiming a free market victory due to the obvious lack of regulation; we are seeing our economy diving into a global meltdown. In fact many of our fine free market corporations are going to the government for free hand-outs of money.

So when will the less regulation crowd do some self-critiquing, self-reflection, and questioning instead of placing the blame on everyone else?

Re: The Real Job of Regulators

So the solution is to add shock absorbers. These actually slow down the suspension system’s response to the bumps. Or, in the economic marketplace, the equivalent of the shock absorbers is the regulators: their job is to make the market respond less efficiently to stimuli. By reducing the responsiveness of the market, they help to dissipate the potential for instabilities and oscillations.

The job of the market regulators is to be inefficient.

If that's how it actually worked, that would be impressive. But it's not.

What really happens is that regulators try to twist the Hot/Cold knob back and forth to find that "just right" temperature, but they always over adjust, and have to over adjust back... so they actually INCREASE the instabilities and inefficiencies and drive efficiencies out of the market. That's bad.

Re: Re: Re: Re: Re:

In most cases they're coming directly from positions as lobbyists for the companies they then proceed to regulate. That strikes me as the problem. Not that regulators are just consistently utterly incompetent. They're utterly incompetent (usually) by design.

I don't know about that... I think you're giving too much credit (or lack thereof) to lobbyists. I think the problem is in thinking that regulators can properly regulate a market. We've seen little evidence that it can be done consistently well by anyone, whether they come from a lobbying background or not.

But I'm not sure I'm grokking Harper/Lee's larger argument that regulation in and of itself is inherently dysfunctional.

I think it's based on the idea that the market itself is usually better at deciding how to deal with a market than a regulator -- and there seems to be pretty good evidence to support that.

Re: Doesn't this Mean the Absence of Regulation!

Second, we are incessantly scolded that we need less regulation to promote the free market. Well, if the regulators aren't doing their job isn't that free market nirvana!!

Uh, not quite. That leaves out the regulatory mess in terms of bureaucracy and inefficiency that folks need to go through just to do common every day things. That's a problem.

Whether or not regulators are successfully stopping fraud doesn't change the fact that you have useless but incredibly costly regulations like SarbOx on the books that basically destroyed the public markets as a route for raising capital.

Instead of hearing the boastful gloating of the anti-regulatory crowd claiming a free market victory due to the obvious lack of regulation; we are seeing our economy diving into a global meltdown. In fact many of our fine free market corporations are going to the government for free hand-outs of money.

Uh, yes, because of ridiculously bad regulations that twisted the way the market performed.

So when will the less regulation crowd do some self-critiquing, self-reflection, and questioning instead of placing the blame on everyone else?

When there's actual evidence that a regulatory regime can actually get things right. Considering we've seen how badly they screwed it up, I can't understand why people are asking to give regulators more power to screw things up even worse.

Re: Re: Doesn't this Mean the Absence of Regulation!

So if the private sector creates financial instruments that exist outside of the regulatory environment, that are structurally flawed, that are not transparent, and are not properly vetted resulting in many companies like Bear Stearns vaporizing it is somehow the fault of regulators?

This is akin to driving your car at 200mph into a light pole and then blaming the police for the accident by not arresting you before you struck the light pole!

Re: The Real Job of Regulators

Mike wrote:

What really happens is that regulators try to twist the Hot/Cold knob back and forth to find that "just right" temperature, but they always over adjust, and have to over adjust back...

No they don’t. It’s the market that provides its own hot/cold knob, not the regulators. It’s the market that keeps adjusting itself back and forth to try to find that “just right” temperature, but always over-adjusting.

The job of the regulators is to get in the way of the water flow, to put some brakes on this continual oscillation. The bad result is that they take the tops off the peaks. But on the other hand, the good result is that they keep the troughs from getting too deep. That’s what they do. We may describe them as “making mistakes”, but it’s all just part of their role.

Re: Re: The Real Job of Regulators

The job of the regulators is to get in the way of the water flow, to put some brakes on this continual oscillation. The bad result is that they take the tops off the peaks. But on the other hand, the good result is that they keep the troughs from getting too deep. That’s what they do. We may describe them as “making mistakes”, but it’s all just part of their role.

I wish that were true, but there's little, if any, evidence to support that.

Regulation is never going to be effective with bodies as huge as megacorporations and the federal government. Both have to be shrunk down, the government to its bare minimum functional size, while corporations shouldn't be allowed to grow beyond a certain point. The larger something becomes, the harder it is to keep it under control. Corporations should be automatically split into a number of smaller, non-profit sharing companies once they reach the regional level, and those companies who are already past that size should be split as well until the companies they're divided into fall below the size limit. While nothing can make regulation perfect, at least it makes th regulated bodies somewhat more manageable. And the regulators should be chosen by the people, not the politicians.

"But on Thursday, almost three years after stepping down as chairman of the Federal Reserve, a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform."

Re: Re: Nuclear Power Tangent

Yes, but if the plant is nearing the end of it's useful life anyway, then where's the big loss? Besides, "blowed up power plants" are not the main danger. The main danger is environmental pollution.

Would you remove the brakes on your car to save some money? No, that'd be stupid, as would side stepping safety in a nuclear plant.

How naive. Experience has shown that many people would. That's why we have mandatory vehicle safety inspections.

You lose a couple plants to cost cutting, and good luck trying to get money to build another one. Who the hell would fund the venture, because it certainly isn't making money with no working power plants.

As long as the cost cutting outweighs the loss then the answer is "those who want to maximize profits".

No to mention the lawsuits said blowed up power plants would create from families of dead victims, sick victims, and property damage.

No problem. The law protects investors from such liabilities. They just take their profits, the company ceases operations, and the victims are just, well, victims.